Time Value and Intrinsic Value

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Time Value and Intrinsic Value</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"> <p class="word_list"><a href="#at-the-money">at-the-money</a><p class="word_list"> <a href="#expiration value">expiration value</a><p class="word_list"> <a href="#in-the-money">in-the-money</a><p class="word_list"> <a href="#intrinsic value">intrinsic value</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"> <p class="word_list"> <a href="#premium">option premium</a><p class="word_list"><a href="#option valuation">option valuation</a><p class="word_list"> <a href="#out-of-the-money">out-of-the-money</a><p class="word_list"> <a href="#time value">time value</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">Because an <a href="../articles/option.htm">option</a> grants the holder a right, it has value for the holder. It represents a liability for the issuer. <b> <a name="option valuation">Option valuation</a></b> is any procedure for assigning a <a href="../articles/valuation.htm"> <strong style="font-weight: 400">market value</strong></a> to an option. This is especially important when an option is issued, since the issuer will want to charge a reasonable price—what is called the <b> <a name="premium">premium</a></b>—for the option.</p> <p class="body">An option's <b><a name="expiration value">expiration value</a></b> is its market value at expiration. In the case of a <a href="../articles/option.htm">call</a>, expiration value (per unit of <a href="../articles/notional_amount.htm">notional amount</a>) is either:</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">zero, or</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">the difference between the value of the <a href="../articles/option.htm">underlier</a> and the <a href="../articles/option.htm">strike price</a>, </p> <p class="body">whichever is greater. </p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table6"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Market Value of a Call at Expiration</span><br> <span class="exhibit_subheader">Exhibit 1</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td><img border="0" src="../images/ex1_option_valuation.gif" width="350" height="175"></td> </tr> <tr> <td> <p class="exhibit_legend">This exhibit illustrates how the expiration value of a call option (per unit of notional amount) varies with the value of the underlier at expiration. If, at expiration, the underlier value is below the strike price, the option expires worthless. Otherwise, its expiration value is the value of the underlier less the strike price.</td> </tr> </table> </center> </div> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table7"> <tr> <td align="right" width="9" height="10"></td> <td width="336" height="10"> <font size="2"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">Consider a call option on 200 ounces of gold struck at <a href="../articles/currency_codes.htm">USD</a> 375. If the market price of gold is USD 400 when the option expires, then the call's USD expiration value will be:</p> <p class="body" align="center">200 <i>max</i>( 0 , 400 – 375 ) = 5000.</p> <p class="body">This reflects the fact that the option holder can exercise the option to purchase 200 ounces of gold for USD 375 per ounce, and then immediately sell the 200 ounces at the market price of gold, which is USD 400 per ounce. </p> <p class="body">Suppose instead that the price of gold were USD 360 when the option expired. In this case, it would make no sense for the option holder to pay USD 375 for gold when the market price is only USD 360. The option holder would not exercise the option, and it would expire worthless. Its market value at expiration would be:</p> <p class="body" align="center">200 <i>max</i>( 0 , 360 – 375 ) = 0.</p> <p class="body">In the case of a <a href="../articles/option.htm">put</a>, its expiration value (per unit of notional amount) is either:</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">zero, or</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">the difference between the strike price and the current value of the underlier, </p> <p class="body">whichever is greater. </p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table8"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Market Value of a Put at Expiration</span><br> <span class="exhibit_subheader">Exhibit 2</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td><img border="0" src="../images/ex2_option_valuation.gif" width="350" height="175"></td> </tr> <tr> <td> <p class="exhibit_legend">For each unit of notional amount, the market value of a put option at expiration is equal to either zero or the difference between the strike price and the underlier value, whichever is greater.</td> </tr> </table> </center> </div> <p class="body">Consider a put option on 200 ounces of gold struck at USD 400. If the market price of gold is USD 380 when the option expires, then the put's USD expiration value will be:</p> <p class="body" align="center">200 <i>max</i>( 0 , 400 – 380 ) = 4000.</p> <p class="body">This reflects the fact that the option holder can purchase gold at the market price of USD 380 and then exercise the put, selling the same gold for USD 400.</p> <p class="body">Option valuation is more complicated prior to an option's expiration. A useful notion is that of <b><a name="intrinsic value"> intrinsic value</a></b>, which is simply what the option's value would be if the option were about to expire. Prior to expiration, an option's market value will generally exceed its intrinsic value by an amount that is called the option's <b><a name="time value">time value</a></b>. </p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table9"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Components of Option Market Value</span><br> <span class="exhibit_subheader">Exhibit 3</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td><img border="0" src="../images/ex3_option_valuation.gif" width="350" height="175"></td> </tr> <tr> <td> <p class="exhibit_legend">Prior to expiration, the market value of an option comprises two components: intrinsic value and time value. This is illustrated for a call option.</td> </tr> </table> </center> </div> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="130" align="left" id="table10"> <tr> <td width="120" height="10"> <font size="2"> </font></td> <td width="10" height="10"></td> </tr> <tr> <td width="120"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="10"> </td> </tr> </table> <p class="body">For example, consider a call option on gold that is struck at USD 400 and will expire in three months. If the current price of gold is USD 390, is the option worthless? Would you be willing to give this option away for free? Certainly not! The option has no intrinsic value, but three months remain until it expires, and the price of gold may rise during that time. The option has time value.</p> <p class="body">An option is said to be <b><a name="at-the-money"> at-the-money</a></b> if the underlier value currently equals the strike price. Otherwise, the option is said to be <b><a name="in-the-money"> in-the-money</a></b> if it has positive intrinsic value, or <b> <a name="out-of-the-money">out-of-the-money</a></b> if it has zero intrinsic value. A call is in-the-money if the underlier value is above the strike price. A put is in-the-money if the underlier value is below the strike price.</p> <p class="body">While intrinsic value is easy to calculate, time value is more difficult to calculate. Historically, this made it difficult to value options prior to their expiration. 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Read Baird (<a target="_blank" href="http://www.riskbook.com/link/baird_a_(1993).htm">1993</a>) after you read Natenberg.</p> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table14"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap367"> <area target="_blank" href="http://www.riskbook.com/link/kolb_r_(2002).htm" shape="rect" coords="0, 0, 92, 124"> </map> <img border="0" src="../images/book_kolb_r_(2002)_125.gif" usemap="#FPMap367" width="93" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table15"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/kolb_r_(2002).htm"> Futures, Options and Swaps</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Robert Kolb</b></td> </tr> <tr> <td width="10%"> <map name="FPMap502"> <area href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="1, 2, 89, 15" target="_blank"></map> <img border="0" src="../images/star_4.gif" usemap="#FPMap502" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <map name="FPMap316"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map><img border="0" src="../images/tech_2.gif" usemap="#FPMap316" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2002</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap366"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/kolb_r_(2002).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap366" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table16"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap500"> <area target="_blank" href="http://www.riskbook.com/link/cox_and_rubinstein_(1985).htm" shape="rect" coords="0, 0, 80, 124"> </map> <img border="0" src="../images/book_cox_and_rubinstein_(1985)_125.gif" usemap="#FPMap500" width="81" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table17"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/cox_and_rubinstein_(1985).htm"> Options Markets</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>John C. Cox and Mark Rubinstein</b></td> </tr> <tr> <td width="10%"><map name="FPMap499"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_classic.gif" usemap="#FPMap499" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <map name="FPMap427"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map><img border="0" src="../images/tech_2.gif" usemap="#FPMap427" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">1985</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap498"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/cox_and_rubinstein_(1985).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap498" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table18"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap501"> <area target="_blank" href="http://www.riskbook.com/link/natenberg_s_(1994).htm" shape="rect" coords="0, 0, 82, 124"> </map> <img border="0" src="../images/book_natenberg_s_(1994)_125.gif" usemap="#FPMap501" width="83" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table19"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/natenberg_s_(1994).htm"> Option Volatility & Pricing</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Sheldon Natenberg</b></td> </tr> <tr> <td width="10%"> <img border="0" src="../images/star_5.gif" usemap="#FPMap563" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <img border="0" src="../images/tech_2.gif" usemap="#FPMap564" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">1994</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap497"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/natenberg_s_(1994).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap497" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table20"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap504"> <area target="_blank" href="http://www.riskbook.com/link/baird_a_(1993).htm" shape="rect" coords="0, 0, 82, 124"> </map> <img border="0" src="../images/book_baird_(1993)_125.gif" usemap="#FPMap504" width="83" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table21"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/baird_a_(1993).htm"> Option Market Making</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Allen Jan Baird</b></td> </tr> <tr> <td width="10%"> <img border="0" src="../images/star_5.gif" usemap="#FPMap563" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <img border="0" src="../images/tech_2.gif" usemap="#FPMap564" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">1993</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap503"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/baird_a_(1993).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap503" width="146" height="20"></td> </tr> </table> </td> </tr> </table> </td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_1.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%">  <p class="ad_legend" style="margin-left: 0; 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